Why do prices rise, and why does it matter?
What inflation is and how it is measured by the CPI, the causes of inflation, the effects of inflation, and the meaning of deflation.
A focused answer for AQA GCSE Economics on what inflation is, how the CPI measures it, the causes of inflation, its effects, and what deflation means.
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What this dot point is asking
AQA wants you to define inflation, explain how it is measured by the Consumer Prices Index (CPI), explain its causes, evaluate its effects, and explain what deflation is. The CPI is an index number, so you should be able to read price-index figures and calculate an inflation rate as a percentage change.
What inflation is and how it is measured
The UK measures inflation using the Consumer Prices Index (CPI):
- A representative basket of around 700 goods and services is chosen to reflect typical household spending.
- Each item is weighted by how much households spend on it, so a rise in the price of housing or food matters more than a rise in the price of postage stamps.
- The basket's cost is recorded as an index number set to 100 in a base year. The percentage change in the index from one year to the next is the inflation rate.
Causes of inflation
- Demand-pull: higher consumer spending, investment, government spending or net exports raise total demand. If the economy is near full capacity, prices rise rather than output.
- Cost-push: higher input costs (an oil-price shock, a fall in the pound raising import costs, or wage rises above productivity) push up firms' costs, which they pass on as higher prices.
Effects of inflation
- Savers lose, as the real value of savings falls if interest is below inflation.
- Borrowers can gain, as the real value of debt falls.
- Exports become less competitive if UK prices rise faster than abroad, worsening the balance of payments.
- Uncertainty rises, discouraging investment and long-term planning.
- Menu costs (changing prices) and shoe-leather costs (searching for the best deals) add to firms' and consumers' burdens.
- Workers on fixed incomes or fixed wages see their real income fall.
Deflation
Worked example
Try this
Q1. Define inflation. [2 marks]
- Cue. A sustained rise in the general level of prices, reducing the purchasing power of money.
Q2. Explain one group that loses from high inflation. [3 marks]
- Cue. Savers lose because the real value of their savings falls as prices rise faster than interest.
Exam-style practice questions
Practice questions written in the style of AQA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
AQA 20196 marksExplain the difference between demand-pull and cost-push inflation.Show worked answer →
Demand-pull inflation is caused by total demand growing faster than supply. When spending rises but the economy cannot produce more quickly, too much money chases too few goods and prices are pulled up. It is common in a boom.
Cost-push inflation is caused by rising costs of production, such as higher wages, raw materials or energy. Firms pass these higher costs on as higher prices, even if demand has not risen.
A 6 mark answer makes clear that demand-pull comes from the demand side (more spending) while cost-push comes from the supply side (higher costs), and develops each with a short example such as an oil-price rise for cost-push.
AQA 20214 marksA price index rises from 100 in the base year to 106 the following year, then to 110.2 the year after. Calculate the inflation rate in the second year. Show your working.Show worked answer →
The inflation rate is the percentage change in the price index from one year to the next, not the change from the base year.
From 106 to 110.2 the change is . As a percentage of the starting figure: , which rounds to about .
So inflation in the second year is roughly . Markers reward using the previous year (106) as the base of the calculation, not 100, and showing the percentage-change method. Using 100 by mistake would wrongly give .
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Sources & how we know this
- AQA GCSE Economics (8136) specification — AQA (2017)